A Primer On Inflation, The No. 1 Thing That Will Kill Your Nest Egg

Inflation instantly brings to mind images of rising prices, shrinking paychecks and unhappy consumers, but is inflation all bad?

Inflation is defined as a "sustained increase in the general level of prices for goods and services."

Many consumers fear inflation because it reduces the purchasing power of their money. The influence that inflation has on consumers in the United States and other developed nations can be seen in gasoline prices, to name one example.

When the price of gasoline goes up, it costs you more money to fill up your vehicle at the gas pump. Although the amount of money allocated to fuel takes a bigger percentage of your paycheck, you get the same amount of gas. This hit to your bottom line leaves you with less money to spend on other items.

In less-developed countries, food price inflation is an ever-greater concern. When the price of basic food items increases significantly, low-income consumers experience severe hardships. In recent years, food price inflation has resulted in public demonstrations and rioting in numerous countries across the globe, including Chile, Morocco, Tunisia and Algeria.

Measuring InflationThere are several ways to measure inflation. Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI). The Bureau of Labor Statistics releases the CPI monthly. It calculates the cost to purchase a fixed basket of goods as a way of determining how much inflation is occurring in the broad economy as an annual percentage increase. For example, a headline inflation figure of 3% equates to a monthly rate that, if repeated for 12 months, would create 3% inflation for the year.

The headline inflation figure is not adjusted for seasonal changes in the economy or for the often-volatile elements of food and energy prices. Headline inflation is the measure that has the most meaning for consumers, as we have to eat food and fuel our cars.

Core inflation, which is the Federal Reserve's preferred yardstick, is a measure of inflation that excludes food and energy. Core inflation eliminates these items because they can have temporary price shocks that can diverge from the overall trend of inflation and give what the prognosticators at the Federal Reserve view as a false measure of inflation. Core inflation is most often calculated by taking the Consumer Price Index and excluding certain items (usually energy and food products). Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation.

Several variations on inflation are also worth noting. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in a single month.

Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices. At the other end of the spectrum is deflation, which occurs when the general level of prices is falling.

This is the opposite of inflation.

The Good Side of InflationInflation has such a negative connotation that many people fail to consider the good side of inflation. Yes, inflation means that it costs more money to purchase items that were previously available at a lower price.

However, it can also mean that the prices of homes, precious metals, stocks, bonds and other assets are rising. For the owners of those assets, inflation can have a wealth-building effect. Inflation can also result in rising wages. If wages rise as quickly as the cost of goods and services, then the rising wages can offset the rising prices.

Monetary PolicyThe United States, Great Britain and some other nations have set targets for the desired inflation rate. A January 2012 press release issued by the Federal Reserve's Federal Open Market Committee sums up the policy in the U.S. and highlights the reasons behind it.

"The inflation rate over the longer run is primarily determined by monetary policy, and hence, the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates, and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances."

That short paragraph sum up a complex and controversial set of issues. It starts with the Federal Reserve (Fed), the central bank in the U.S. and its dual objectives of maintaining a modest level of inflation and a low rate of unemployment. In order to achieve these objectives, the Fed controls monetary policy. The term "monetary policy" refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and spend it, and this spending will then foster economic growth. Similarly, if interest rates increase, it costs more to borrow money. When this happens, fewer people and firms borrow money, which results in decreased spending and slower economic growth.

The Bottom LinePutting it all together, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. This fuels inflation. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. It all sounds simple enough until you view it in the context of the many other factors that influence the economy in the U.S. In this larger context, monetary policy, inflation and just about everything else associated with these topics become fodder for economists, politicians, academics and just about everyone else to discuss and debate.